Fitch falls into formation

Fitch Ratings has affirmed South Africa’s Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) at ‘BBB-‘ and ‘BBB’, respectively. The issue ratings on South Africa’s senior unsecured foreign- and local-currency bonds are also affirmed at ‘BBB-‘ and ‘BBB’, respectively. The Outlooks on the Long-Term IDRs are Stable. The Short-Term Foreign-Currency IDR is affirmed at ‘F3’.

KEY RATING DRIVERS

The ‘BBB-‘ rating reflects low trend GDP growth, significant fiscal and external deficits, and high debt levels, which are balanced by strong policy institutions, deep local capital markets and a favourable government debt structure.

Political risk has increased since the previous rating review in December 2015, although it is not out of line with ‘BBB’ peers. The dismissal of two finance ministers in a week in December, and subsequent tensions between the new finance minister Pravin Gordhan and other parts of the government have raised questions about the commitment of the government to sustained fiscal consolidation and prudent governance of state-owned enterprises.

President Jacob Zuma has become increasingly embattled following the Constitutional Court ruling that he should repay some public funds used to refurbish his Nkandla residence and the Gauteng high court’s ruling that the previous suspension of a 2009 corruption case against Zuma was irrational. Nevertheless, institutions have proved robust. However, Fitch expects the governing African National Congress (ANC) may lose some support in local elections on 3 August 2016. Tensions within the ANC are also increasing ahead of the conference in December 2017 to elect Zuma’s successor as ANC president.

Fitch views political risks mainly in terms of the impact on the economy and public finances. Fitch’s base case is that the government remains committed to fiscal objectives set out in February’s budget, but political tensions increase risks to progress on fiscal consolidation and growth-enhancing measures, and raise the chances of policy missteps.

Trend GDP growth remains low compared to that of its peers, with five-year average GDP growth at just 2.2% compared to a ‘BBB’ median of 3.3%. GDP growth was 1.2% in 2015 and is likely to slow to just 0.7% in 2016 before recovering to 1.5% in 2017. Growth is held back by constrained electricity supply, concerns about the deteriorating investment climate and fractious labour relations.

The government has made progress in addressing power supply problems, with no load shedding so far this year, as maintenance management has improved and additional renewable power sources have been added to the grid, although new units from the Kusile and Medupi coal-fired power stations will only come on line in 2018.

Other government efforts to boost growth are likely to have only a marginal impact. The strategy includes the creation of a public-private fund to support SMEs, the use of more private-sector funds to build infrastructure modelled on the Independent Power Producer renewable power programme, reducing uncertainty and administrative hurdles for companies and efforts to improve labour relations. At the same time, other initiatives, such as the planned national minimum wage, the recently approved land expropriation bill and the planned revision of the mining charter could deter investment.

External finances remain a weakness. The current-account deficit stood at 4.3% of GDP in 2015, compared to a ‘BBB’ median of 1.4%. Fitch expects only a moderate improvement for 2016, driven by lower imports in the face of weak domestic demand and the recent substantial depreciation of the rand. However, the impact of a noticeable improvement in export volume growth over the last three quarters has been partly offset by weakening export prices, due to the commodity price decline. Net external debt stood at 13.6% of GDP in 2015, compared to a peer median of 3.9%. However, the risks are mitigated by a flexible exchange rate and the favourable composition of public external debt, which is largely in local currency and has long maturities.

Fiscal deficits have remained high, with a deficit of 3.9% of GDP in the fiscal year ended 31 March 2016 (FY16), but the government in the FY17 budget introduced tax measures to raise revenue by 0.4% of GDP in 2016/17. Further measures are to be introduced over the following two years, bringing cumulative tightening to around 1% of GDP per year by FY19. The government projects that this will bring the deficit to 3.2% of GDP in FY17, 2.8% of GDP in FY18 and 2.4% of GDP in FY19 so that the central government debt/GDP would peak at 51% of GDP in FY18.

Achieving these targets will be challenging given that GDP growth is likely to underperform. In addition, pressures to raise expenditure are rising due to increasing disaffection with poor public-service delivery and any weakening of support for the ruling ANC in local elections in August may add a greater sense of urgency to address this. However, revenue estimates underlying the deficit projections have been conservative and the National Treasury has a strong track record of keeping expenditure below ceilings set out in its Medium-Term Expenditure Framework, so deficits are likely to over-shoot targets only slightly. Fitch expects the deficit to stand at 3.3% of GDP in FY17 and 3% in FY18, leading to general government debt of 53.3% of GDP in FY18.

Inflation picked up to 7% in February 2016 before decelerating to 6.2% in April, above the inflation target of 3%-6%. The South African Reserve Bank (SARB) has reacted by raising interest rates by a total of 200 basis points to 7% since 2014. The fact that SARB has tightened in an environment of weak economic growth underlines its strong independence and commitment to containing inflation.

Many structural indicators, such as per capita income, are somewhat weaker than those of ‘BBB’ category peers, although governance indicators are slightly stronger. The banking sector remains sound due to prudent regulation, although the weak economy will increasingly affect asset quality and profitability. Impaired loans are likely to rise, but only moderately and from a low level of 3.4% of total loans at end-March 2016.

SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)

Fitch’s proprietary SRM assigns South Africa a score equivalent to a rating of ‘BBB’ on the Long-Term Foreign-Currency IDR scale.

Fitch’s sovereign rating committee adjusted the output from the SRM to arrive at the final Long-Term Foreign-Currency IDR by applying its QO, relative to rated peers, as follows:
– Macroeconomics: -1 notch to reflect South Africa’s weaker potential growth prospects relative to the ‘BBB’ median, with important repercussions for public finances.

Fitch’s SRM is the agency’s proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a Long-Term Foreign-Currency IDR. Fitch’s QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

RATING SENSITIVITIES

The following risk factors, individually or collectively, could trigger negative rating action:
– A loosening of fiscal policy, such as upward revisions to expenditure ceilings, leading to a failure to stabilise the ratio of government debt/GDP; or an increase in contingent liabilities.
– Failure of GDP growth to recover sustainably, for example due to a lack of policy changes to improve the investment climate.
– Rising net external debt to levels that raise the potential for serious financing strains.
– Heightened political instability that adversely affects the economy or public finances.

The following risk factors, individually or collectively, could trigger positive rating action:
– A track record of improved growth performance, for example bolstered by the successful implementation of growth-enhancing structural reforms.
– A marked narrowing in the budget deficit and a reduction in the ratio of government debt/GDP.
– A narrowing in the current-account deficit and improvement in the country’s net external debt/GDP ratio.

KEY ASSUMPTIONS

The agency assumes the South African Reserve Bank remains committed to maintaining inflation within its 3%-6% inflation target.